Monday, October 13, 2008

Nathan Gardels of the Huffington Post interviewed financier George Soros Sunday at the IMF - World Bank meeting in Washington D.C..

Soros predicts a global "powershift toward Asia." He says the financial crisis calls for a new "paradigm" by which markets need to be understood -- and regulated.

Of course, Soros has been speaking out for a long time on these subjects. In the Huffington Post interview, Soros reiterates his view as to the underlying problem behind the market collapse:

The key to understanding this crisis -- the worst since the 1930s -- is to see that it was generated within the financial system itself. What we are witnessing is not the result of some exogenous shock that knocked things off balance, as the prevailing paradigm, which believes markets are self-correcting, would suggest. The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.

The paradigm I'm proposing differs from the conventional wisdom in two respects. First, financial markets don't reflect the actual economic fundamentals. Expectations by traders and investors are always distorting them. Second, these distortions in the financial markets can affect the fundamentals -- as we see in both bubbles and crashes. Euphoria can lift housing and dot.com prices; panic can send sound banks tumbling.

That two-way connection -- that you affect what you reflect -- is what I call "reflexivity." That is how financial markets really work. Their instability is now spreading to the real economy, not the other way around. In short, the boom-bust sequences, the bubbles, are endemic to the financial system.

The current situation is not just about the housing bubble. The housing bubble was merely the trigger that detonated a much larger bubble. That super-bubble, created by the ever-increasing use of credit and debt leverage, combined with the conviction that markets are self-correcting, took more than 25 years to grow. Now it is exploding.

George Soros told AFP Sunday that the Paulson plan "was basically the same kind of financial engineering that got us into the trouble that they wanted to use for getting us out of it." As for the Administration's efforts to date, Soros told Gardels:

The U.S. authorities bought into market fundamentalist ideology. They thought that the markets would ultimately correct themselves. U.S. Treasury Secretary Henry Paulson epitomized this. He thought that six months after the Bear Stearns crisis the market would have adjusted and, "Well, if Lehman (Brothers) goes bust, the system can take it." Instead, everything fell apart.

Since they did not understand the nature of the problem -- that the market would not correct itself -- they did not see the need for government intervention. They did not prepare a Plan B.

As the shock of the Lehman failure set in, he had to change his mind and rescue AIG. The next day there was a run on the money markets and commercial paper markets, so he turned around again and said we need a $700 billion bailout. But he wanted to put the money in the wrong place -- taking the toxic securities out of the hands of the banks.

They have finally now come around -- with the government buying equity in banks -- because they see the financial system is on the verge of collapse.

Gardels asked Soros what should be done next. Soros replied:

The outlines are clear. There are five major elements.

First, the government needs to recapitalize the banking system by buying equity stakes in banks.

Second, interbank lending needs to be restarted with guarantees and bringing LIBOR (London Interbank Offered Rate) in line with Fed funds. This is in the works. It is going to happen.

Third, we must reform the mortgage system in the U.S., minimizing foreclosures and renegotiating loans so that mortgages are not worth more than houses. Stemming foreclosures will cushion the fall of housing prices.

Fourth, Europe has to fix a weakness of the Euro by creating a safety net for its banks. While initially resisting this, they have now found religion and done it at their meeting in Paris on Sunday.

Fifth, the IMF must deal with the vulnerability of countries at the periphery of the global financial system by providing a financial safety net. This is also in the works. The Japanese have already offered $200 billion for this purpose.

These five steps will start the healing process. If we implement these measures effectively, we will have passed through the worst of the financial crisis.

But then, I'm afraid, there is the fallout in the real economy, which is now gathering momentum. At this point, repairing the financial system will not stop a severe worldwide recession. Since, under this circumstance the U.S. consumer can no longer serve as the motor of the world economy, the U.S. government must stimulate demand.

Because we face the menacing challenges of global warming and energy dependence, the next administration should direct any stimulus plan toward energy savings, developing alternative energy sources and building green infrastructure. This stimulus can be the new motor for the world economy.

As if Soros' vast fortune was not persuasive evidence that this financier has understood the defects inherent in today's capital markets, it must be said that the recent turn of events has followed the financier's predictions rather closely.

That governments appear to have begun following Soros' advice is welcome news.